Permanent productivity differentials and Optimal Currency Areas

Many good economists, like Simon Johnson and Paul Krugman for example, have said something about permanent productivity differentials and optimal currency areas I simply do not understand. (Lots of other people say the same thing, but when good economists say it and I don't understand it I get worried.) Maybe they are making some implicit assumption that I'm just missing. Or maybe I am misunderstanding what they are saying. Or maybe, just maybe, what they are saying doesn't make any sense.

{Update: Hmmm, on re-reading both those economists a third time, maybe they are saying something different from what the others are saying. But it's still not clear to me.)

This is what I think they are saying (I could be wrong):

If two countries have a permanent difference in productivity levels, (or a permanent difference in productivity growth rates, or do not converge in productivity over time), then that is one reason why those two countries do not belong in the same Optimal Currency Area. Unless there are fiscal transfers from the high productivity country to the low productivity country.

That's what doesn't make sense to me.

I understand why asymmetric shocks, including asymmetric shocks to productivity, are one reason why two countries do not belong in the same OCA. Because real exchange rates may need to adjust quickly in response to asymmetric shocks, and nominal wages and prices might be slow to adjust, and nominal exchange rates can adjust more quickly.

And I think I understand why fiscal transfers from the country experiencing temporarily high productivity to the country experiencing temporarily low productivity might help alleviate the problems a fixed exchange rate creates in the presence of those asymmetric shocks. Because fiscal transfers might mean the real exchange rate doesn't need to adjust as much in response to asymmetric shocks.

But I don't understand why the exchange rate regime matters for permanent productivity differentials. And so I don't understand why fiscal transfers would make the exchange rate regime matter less. You can't make something matter less if it doesn't matter at all.

Assume that Canadians are permanently only half as productive as Americans. Always have been and always will be. It's something in the water.

Does that mean it would be better to peg the exchange rate at 50 cents US rather than at par, just so that Canadians could feel good about having the same dollar incomes as Americans, even though we are getting paid in different dollars that are worth only half as much? Would it make any difference if our dollars were the same, but we only got paid half as many? I can't see why it should make any difference.

And sure it would be nice if the rich Americans gave us poor Canadians some fixed fraction of their income every year. But it would be equally nice whether we convert their dollars into the same number of Canadian dollars that were worth the same amount, or into twice as many Canadian dollars that were only worth half the amount.

Maybe, just maybe, there is indeed some sort of permanent money illusion, so that Canadians would insist on being paid the same as Americans only if we call our currency by the same name, even though we are only half as productive. So we suffer permanently higher unemployment that could be eliminated if we switched to calling our dollar after an aquatic bird so people stop making the comparison with American incomes. But if that's the case, maybe we should also pay lower productivity workers in cents, rather than in dollars, so they are satisfied getting the same million cents salary as those who get a million dollars.

I don't think this is what good economists like Simon Johnson and Paul Krugman would be assuming. There must be something else. Some other hidden (to me) assumption they are making. What is it?

Maybe they are assuming that permanent productivity differentials cause asymmetric shocks? That if the Greeks and Germans became equally productive then the Greeks would start building BMWs and the Germans would start growing olives, so that any shocks would hit both economies more equally? But if that's the case, then the relation between productivity and OCAs could go either way. That's because the main benefit of a common currency is that it's supposed to make trade easier, and if two countries became more alike they would tend to benefit less from trade.

Maybe there's some sort of link between permanent productivity differentials, balance of payments deficits, and exchange rate regimes? But I can't figure it out. The link between permanent productivity and the balance of payments isn't obvious, and the link between those two and the exchange rate regime is even less obvious.

Anyway. I just want to try to make sense of this argument. There are lots of other arguments against common currencies that do make sense to me. But this one doesn't. What am I missing?

[This post is an attempt to be clearer than I was in my previous post on the same subject, where lots of good commenters didn't get my point, which means I wasn't making it clearly enough.]

"Maybe they are assuming that permanent productivity differentials cause asymmetric shocks? That if the Greeks and Germans became equally productive then the Greeks would start building BMWs and the Germans would start growing olives, so that any shocks would hit both economies more equally?"

PK and SJ are assuming that permanent productivity differentials, especially when those differentials are driven by capital rich/capital poor, will imply capital flows to poor, which is equivalent to a CA deficit. That means that the capital poor country is getting over-leveraged over time.

It's not the productivity, its the leverage.

Without the adjustment mechanism of the exchange rate a sudden stop is inevitable. Unless the capital poor and capital rich areas can be treated as having a consolidated balance sheet.

That's my reading, at any rate... so, no, its not productivity that's the problem, exactly.

A simple assumption that seems sufficient is that groups with different productivity levels are more likely to have lower correlation of productivity changes. Your 1/2 as productive example is implicitly assuming tight correlation.

Nick, when you put it this way, I'm equally confused. I don't see a problem with long-run productivity differentials as such (although maybe they lead to problems, as argued in BSEconomist's comment above). The problem is the combination of low labor mobility, lack of fiscal transfers, downward-sticky nominal wages, and heterogeneity (which leads to asymmetric shocks, but as you point out, it also underlies the justification for trade, and therefore for a common currency, in the first place). I think you would have the same problem even without a long-run productivity differential. (I'm not even sure how much sense it makes to compare productivity across regions that are producing different things. How productive are German factory workers at making olive oil? Or at accommodating tourists on the Mediterranean?) You would still get asymmetric shocks, and the results could still be disastrous.

A better high/low productivity shock example, I think, is the emergence of China and the developing world. Portugal and Greece generally compete directly with those countries in manufacturing, such as textiles. On the other hand, Germany exports complicated capital equipment that are in high demand as China expands factories and infrastructure.

Maybe they are assuming that permanent productivity differentials cause asymmetric shocks? That if the Greeks and Germans became equally productive then the Greeks would start building BMWs and the Germans would start growing olives, so that any shocks would hit both economies more equally?

Olives and BMWs are a function of climate and neighborhood effects, surely. Trade is still improving.

I read it as implicitly claiming permanent productivity differentials give regional governments different policy trade-offs over time, both 'at equilibrium' and in response to general recession. Simon Johnson emphasizes the diverging policy regimes of core and periphery, for example. But OCA requires a unitary monetary and fiscal response.

Addendum: thinking about it, the jump toward fiscal transfers is obviously an allusion to the standard OCA result. Krugman emphasizes this, but not Johnson. But it is easy to justify Krugman here: permanent productivity differentials induce different regional policy responses to a general shock; thus regional shocks then diverge anyway.

They are making no sense. Look at any country, you have college educated engineers living with high school drop outs. That's a permanent productivity offset and under one currency. Krugman wants to claim this only works because of fiscal transfers? Arguably there is no mobility between these groups either.

That sounds like his politics creeping out again.

My guess is that they are giving an answer they like politically but learned as old keynesians. That is that these subsets have different levels unemployment and through some Philips curve magic he wants the CB to fix it.

Witness also that Karl has been pounding the table about targeting unemployment.

When Krugman refers to the widespread perception of "backward, semi-developed countries like Greece or Portugal (not my view, but what you often hear) awkwardly tied to powerhouses like Germany" he most likely has in mind the idea that we expect productivity growth in Germany to outstrip that in Greece.

Note that he explicitly says "not my view" before going on to say that the data is inconsistent with that view in any case. Also, he's "in an undisclosed location actually being a human being for a few days" so I suspect this is not one of his more carefully considered posts.

But it is surely true that if differences in productivity growth rates are immutable, due to something in the water as you put it, that is one more reason why EMU isn't going to work. Differences in productivity levels shouldn't be a problem.

Kevin: it is possible that Paul Krugman was saying that permanent productivity differentials have nothing to do with OCA whether or not there are fiscal transfers. And the bit at the end about fiscal transfers was just a BTW (and an excuse to put the boot into the Republicans).

"But it is surely true that if differences in productivity growth rates are immutable, due to something in the water as you put it, that is one more reason why EMU isn't going to work."

I don't get that either. If Americans have a productivity growth rate permanently 1% higher than Canadians, due to something in the water, then we could simply have nominal per capita income growth permanently 1% higher in the US than in Canada. Unless the North American inflation target was too low, so this would mean occasional negative nominal wage growth in Canada, and there's absolute downward nominal wage rigidity? Even here, I would think the within-country variance would be very large relative to the cross-country variance. (Or am I committing some variant of the Lewontin Fallacy?)

I read the Krugman post as building on a previous post where he noted how large the automatic fiscal stabilizers are in a federation (using Florida as an example).

http://krugman.blogs.nytimes.com/2012/06/02/florida-versus-spain/

The implication being that sizable fiscal stabilization and equalization occurs in a federation (that has a large federal government), preventing financial and economic crises from becoming currency crises, regardless of productivity differences between regions.

If the ECB was setting the target it would be under 2%. So the scenario Krugman is toying with is one where the ratio of Greek to German wages needs to fall steadily. That's easily accomplished if the Germans are paid in D-marks and the Greeks are paid in drachmas. But if both are paid in Euros, and the Germans are content with very modest increases, then the Greeks must take regular pay cuts.

However he doesn't endorse that worry since there's not much evidence for it really. The big problem is that monetary union requires fiscal union, meaning outright transfers (not loans) on a large scale. That would require us to think of ourselves as citizens of the United States of Europe.

I think your first premise, "good economists," should be examined. Both gentlemen have become staunch polemicists, breathlessly or furiously supporting positions above all. Your analysis is very mainstream and logical.

How succinct. BSEconomist, Fmb, and Andy have this all down. The reason productivity differences don't matter within countries are those fiscal transfers and because because of geographic locality. The less productive specialize in non tradeables allowing increased productivity for them though still less than those in tradeables.

"In this paper, the authors document a growing divergence between current account imbalances in
northern and southern euro area countries from 1992 to 2007. The imbalance occurred without a concomitant rise in productivity and growth in the southern (deficit) countries"

"If two countries have a permanent difference in productivity levels, (or a permanent difference in productivity growth rates, or do not converge in productivity over time), then that is one reason why those two countries do not belong in the same Optimal Currency Area. Unless there are fiscal transfers from the high productivity country to the low productivity country."

This is not what Johnson or Krugman said at all. I was commenting on this the last couple of days and then noticed that Krugman's latest post seemed to borrow what I was saying almost word for word. (Maybe I'm just getting paranoid thinking Krugman is actually reading my comments). Let me explain.

Johnson said the following:

"This amounted to a very big bet that their economies would converge in productivity - that the Greeks (and others in what we now call the "periphery") would, in effect, become more like the Germans."

"In fact, the opposite happened. The gap between German and Greek (and other peripheral country) productivity increased, rather than decreased, over the last decade."

This is unforgivable sloppiness on the part of Simon Johnson. In many peripheral euro countries, or countries pegged to the euro, where there was huge capital inflows, namely Bulgaria, Estonia, Greece, Ireland, Latvia, Lithuania and Spain, productivity (GDP per hour worked) actually grew faster than in Germany over 1999-2007 (in some cases much faster). What Johnson obviously meant to say is that unit labor costs (ULC) did not grow as fast in Germany. That's partly because of German wage supression and partly just an empirical regularity.

Current account generated investment booms normally raise the relative cost of labor. The problem however is when monetary policy swings from relative laxity to relative tightness the drop in aggregate demand hits those countries/states with capital inflows the hardest. See for example the Southwest and Florida in the case of the US.

This distinction between productivity and ULC is important. If permanent differences in productivity mattered in currency unions then the US should not even exist. Productivity in Delaware is roughly double that of Mississippi. It is 50% higher in New York than in Michigan.

But asymmetric shocks can produce temporary differences in ULC, as they have between the core and periphery in the eurozone (and the BELLs) and in the core and periphery in the dollarzone. The main reason why the US has not had the same kind of crises as the eurozone is fiscal transfers. Florida would be our Spain right now if it weren't for the flow of Treasury funds. It's got absolutely nothing to do with permanent productivity differences. It has to do with temporary differences in ULC.

Slower productivity growth explains the decline in euro area potential GDP growth,
while lower labor utilization is behind the lower GDP level with respect to peers. The
sharp decline in total factor productivity growth in the euro area (Figure 2) had the largest
contribution to the trend growth decline observed in the last three decades. While potential
growth rates have come down significantly, the slowdown is more pronounced in the
Southern euro area countries. But productivity is not the entire story: Mourre (2009) shows
that lower labor utilization explains two-thirds of the differential in the GDP per capita level
between the euro area and the United States in 2006. [page 6]

During the last decade, dissimilar patterns of growth across countries and increasing
competitiveness differentials exacerbated each other. Exports drove growth in Northern
euro area countries, while Southern countries relied on domestic demand with a large share
of the employment created in the cyclical and credit-dependent non-tradable sectors, e.g. real
estate. Much of the foreign capital that flew into the Southern euro area during the last
decade was in the form of debt while the tradable sector limped, creating brittle fundamentals
for growth and resource generation for servicing this debt. Relative prices, including nominal
unit labor costs, diverged rendering Southern euro area countries uncompetitive (Figure 3).

One additional clarification. The BELLs (Bulgaria, Estonia, Latvia and Lithuania) are all either pegged to the euro or have been admitted to the eurozone (Estonia). So they are more or less part of the same currency zone.

Nick,
I think you are confused about Johnson and Krugman, because they are confused. Therefore a healthy reaction : - )

Both do not spell out that the problem is productivity, or better: unit labor cost, “CHANGES”. Johnson simply doesn’t get it, that one currency means indeed, no exchange rate changes. This has nothing to do with any productivity changes here and there. Something he just doesn’t get.

And the implicit assumption was also not that any problems would be solved by mobility, “Greek workers would go to Germany”. Nonsense! It would just aggravate the problem, a brain drain! Somebody working in Germany pays ALL their taxes in Germany. A very typical example of US loud mouth myopia, very little knowledge about the situation, not thinking things through, but lots of opinion.
The assumption was also not, that this would be an adaption / convergence process from a state out of equilibrium.

No, we had the currency snake since 1973 (please don’t get pious, who calls what from when on), many European countries were pegging then their currencies against the deutschmark in the 80ties, a convergence period after the Maastricht treaty 1992, and final exchange rate fixing in 1999 (maybe 1998). That was supposed to be a “fair level” starting point.

Actually there was a little bias built in against Germany, based on expected productivity gains in eastern Germany, which didn’t peter out.
Krugman has a point, that the US considered themselves a “Nation” only after the Civil War.

Well, we tried this in Europe for 2000 years, unification by military force, didn’t work, despite so many attempts, and so high the cost. We will NOT try this again.
The rest of Johnson and Krugman are just head fakes, based on the multiple false assumptions, mentioned above.

Now let’s have a look how that was supposed to work, based on Ordnungspolitik.

I am shocked by all the weight put by some commenters in this thread to the role of fiscal transfers.

There are certainly some large transfer payments made in the US; I imagine Canada too. Where did people get the idea these had any macroeconomic function and weren't more than a reflection of comity and social values?

Not all policies of the government need to be justified as growth measures. Sheesh.

ianlee: thanks for bringing empirical research to the discussion. I always feel I learn more when people do that.

What I think I'm learning from this analysis is that many southern (I think "southern" means "poor" in this context) EU members ran big trade deficits with the rest of the EU. The IMF now says this "created brittle fundamentals". We've seen this movie; the IMF offered similarly insightful analysis after the onset of the Asia crisis in 1997 when some of the worst affected countries were blamed for running ongoing current account deficits.

This kind of analysis runs into some problems when you think about it. In neoclassical models of growth, you want to move capital from capital-endowed, richer countries with aging populations ("Northern" countries) to poorer, younger ("Southern") countries where capital is relatively more scarce. If you think that model applies, that means you want "Nothern" countries to run trade surpluses while "Southern" countries run trade deficits. That's what we saw prior to the crisis in Asia in the 90s and in Europe more recently (and don't get me started on Latin America in the 80s....)

In hindsight, however, a crisis causes many to change the ways they thought about those international capital flows. Rather than helping reallocate capital efficiently across nations, they are perceived to be symptomatic of excess consumption rather than productive investment. Many nations stung by such changes in attitudes (think Thailand, Spain or Ireland) are particularly frustrated by the selective nature of the analysis; how much fuss is made about the ongoing current account deficits in the US?

I think story about capital flows is important in understanding the debate about exchange rates. Nick has had some good posts lately about the nature of causality in economics, stressing that sme things are determined simultaneously. That sounds like good advice in thinking about exchange rates and trade deficits. It is often misleading to think that a trade deficit is caused by an exchange rate; the opposite may in fact be true.

So what happens in a currency union like Canada or the EU? What happens when you *want* to move capital from North to South (or East to West) but don't have an exchange rate to help adjust relative prices? It means the price adjustment has to happen by changing nominal prices. If prices are sticky, they move more slowly so the capital does not get transferred as efficiently. Meanwhile, we see relative ULC rise in the capital-importing area (i.e. the South or West) as wages get bid up, land prices there rise, construction trades are in high demand, etc. None of those things are bad; they are all signs that the marginal product of labour and capital are high. They all help the transfer of capital (and other resources, like labour.)

(Hmm....I thought I was talking about Europe, but I seem to have been also talking about Dutch Disease.)

@Jon,
You wrote:
"I am shocked by all the weight put by some commenters in this thread to the role of fiscal transfers.

There are certainly some large transfer payments made in the US; I imagine Canada too. Where did people get the idea these had any macroeconomic function and weren't more than a reflection of comity and social values?"

From OCA.

Optimum currency area (OCA) theory represents a systematic way of deciding whether it makes sense for a geographical region to share a common currency. One often cited criteria for a successful currency union is a risk sharing system such as an automatic fiscal transfer mechanism to redistribute money to regions which have been adversely affected by asymmetric shocks. The European Union budget represents only about 1% of GDP so meaningful fiscal transfers are negligible in practice. Furthermore, Europe had a no bail-out clause in the Stability and Growth Pact, meaning that fiscal transfers were not allowed even in the event of a crisis.

Ah, yes, what Kevin said. In general, the lower is the target inflation rate relative to the productivity growth rate differential, the more vulnerable the currency union will be to asymmetric shocks (when those shocks happen to hit in the same direction as the productivity growth rate differential). If the productivity growth rate differential exceeds the inflation rate, then even a shock of size zero will be sufficient to destabilize the union.

Simon van Norden,
You arote:
"What I think I'm learning from this analysis is that many southern (I think "southern" means "poor" in this context) EU members ran big trade deficits with the rest of the EU."

I think it is incorrect to generalize this as merely "southern" in nature. The nations most affected by the current account reversals were in fact not the the GIIPS (which also includes a "northern" nation) but the BELLS (Bulgaria, Estonia, Latvia and Lithuania). It is true those nations were not on the euro during the crisis but they were pegged to the euro, and they may not be suffering from sovereign debt crises, but I would argue the macroeconomic shock was perhaps even more severe. They are on the road to recovery but Latvia, for example, is not forecast by the IMF to get back to previous peak GDP until 2017.

And:
"Rather than helping reallocate capital efficiently across nations, they are perceived to be symptomatic of excess consumption rather than productive investment."

It is important to underscore the fact that this is more a perception than a reality. Most of the flow of capital to these nations did in fact result in productive investment. The problem is nominal in nature, not real. In my opinion a good dose of aggregate demand simulus to the eurozone would cure most of the current macroeconomic imbalances.

Lord: Jon: Is it that you don't think automatic stabilizers are fiscal transfers or that they have no macro basis?

Correct, pure transfer payments do not contribute to output therefore automatic stabilizers do not take the form of transfer payments. Second, automatic stabilizers only function in the short run with respect to shocks. I think my response to Andy will help understand further.

Andy: I don't know how you can claim to compare the inflation rate to the size of the differential shock. If you have two populations with ibr currency but otherwise in isolation your assumption that the inflation rate is uniform is false. There is no quantity against which your comparison makes sense.

Thought experiment: inflation is fixed by averaging over the two populations--initially the rate is equal in both populations. There is a differential shock. Prices drop in one region, the CB must loosen. An inflation gap will open, inflation will push up in one region at a rate above target even as prices are pushed at a rate below in the other region.

Now the point if a common currency is trade. Even with a permanent productivity differential, the higher rate of inflation in one region is going to drive production to the shocked region until the rates equalize. The productivity of one worker is irrelevant: Th law of one price tells you that one unit of output must be priced the same in both countries. Therefore inflation must be the same. Therefore productivity is irrelevant.

Now the point if a common currency is trade. Even with a permanent productivity differential, the higher rate of inflation in one region is going to drive production to the shocked region until the rates equalize.

The main point of the ECB arrangement was to create common nominal risk-free rates, not trade or a common currency per se. The friction due to currency exchange is negligible. That is not a reason to adopt a common currency. What you are adopting is a common central bank that sets the risk free zero day funding costs for the entire region. It is the convergence of nominal interest rates that you are adopting, which causes a divergence of real rates.

The productivity of one worker is irrelevant: Th law of one price tells you that one unit of output must be priced the same in both countries. Therefore inflation must be the same. Therefore productivity is irrelevant.

What is this "Law of one price"? Who enforces it? Do you really believe prices are the same in Alabama as in San Francisco? Really? Offices that have regional COLA adjustments are just wasting their time? The BLS measures regional inflation rates for no reason? Land prices are not the same, and that means that the prices of any goods that require land to be sold are not the same. Even tradeable goods cost more because the rent must be paid by the retailer, and the retailer must pay a higher wage to staff their store. But of course the bulk of the CPI basket is locally produced services.

And the part about capital moving is funny. I am sure that banks in Manhattan and Firms in Silicon Valley are going to be relocating to Detroit any time now. The firms are where they are because of the productive eco-system. Networks of highly skilled workers combined with networks of highly skilled managers. Credit and supplier relationships. It is because of this ecosystem that the firm moves to the area, not because of the price of yogurt.

Correct, pure transfer payments do not contribute to output therefore automatic stabilizers do not take the form of transfer payments. Second, automatic stabilizers only function in the short run with respect to shocks

From the point of view of the Federal government, California sending money to Florida is a transfer payment and not fiscal policy. But from the point of view of the two states, it *is* fiscal policy. It is a type of re-cycling similar to California creditors lending money to Florida debtors in order to enable them to purchase californian output (the state runs a trade surplus vis-a-vis the rest of the nation).

And this does effect output, in the sense that if these payments were not made, output would be lower.

Similarly, euro-wide, taxing germans to give money to Greeks -- say under the rubric of a common unemployment insurance policy -- might be fiscally neutral in the long run, but it would certainly have positive stabilizing effects and increase real output.

It is a type of re-cycling similar to California creditors lending money to Florida debtors in order to enable them to purchase californian output (the state runs a trade surplus vis-a-vis the rest of the nation).

Is that supposed to convince me that creates output? You're just restating the original claim with a thin of veneer of a story.

If those california creditors hadn't lent money to the florida debtors, they would have bought the california output itself. If they hadn't, inflation would have been lower, the CB would have eased, and then they would have done so. Ergo, the output existed either way.

What you need to show is why these transfer payments within the EU increase EU output. In order for that to be the case you need to show that transfer payments increase efficiency (i.e., that they shift the AS curve)--remember all you've done is change who is doing a particular round of purchasing.

If those california creditors hadn't lent money to the florida debtors, they would have bought the california output itself. If they hadn't, inflation would have been lower, the CB would have eased, and then they would have done so. Ergo, the output existed either way.

The CB would not have eased just for California. That is the whole problem. There are different states with different inflation rates. Manhattan is doing just fine. Detroit is not. The CB is going to respond to the average. Rates will be too low in Manhattan and too high in Detroit.

What you need to show is why these transfer payments within the EU increase EU output.

That is easy. Any form of insurance is going to reduce risk and increase consumption and investment demand. Particularly for those who are credit constrained. The jobless, as a class, are going to be more credit constrained. If the government can borrow at risk free rates (or just tax) and provide income to the unemployed, and then later on tax them when they regain their jobs, that is a much better deal than having the unemployed borrow at credit card interest rates and face fixed payment schedules.

The unemployed are either going to refrain from borrowing or they will borrow at much higher rates. In either case, they will be pushed off of their optimum consumption plans. The unemployment insurance (or income insurance, more generally) reduces income risk and allows them to be closer to their optimum consumption paths.

Nick - this blog (WCI) gets better and better and better. I learn more from this blog than any other source - because arguments herein forces me to re-examine what I am thinking or think that I know or confront assumptions that I did not know I was assuming.

And you are a rare economist - who thinks philosophically - like Deidre McCloskey or Hannah Arendt. From someone who studied political philosophy (Hobbes, Rousseau, Marx,) for his comps, you should be teaching pol theory. Restated, it seems to me that macroeconomics is a variant of political theory that is addressing (wittingly or not) the most important questions that can be or should be asked – and you are raising some of these questions here.

Now let’s have a look how that was supposed to work, based on Ordnungspolitik.

That claim would have some merit if the German Ambassador had not asked Canada to contribute money to the IMF to bail out Europe. The ambassador did ask.

ISTM that the Euro violated the key aspects of a "sovereign" when it came to borrowing and money.

I say the aspects are:

1) One top government for the currency area. Provinces, states and municipalities nice but not necessary.
2) That top government has unlimited power to levy taxes from its citizens in its own currency.
3) There is one central bank which sets interest rate policy for the country and which serves as fiscal agent to the government.
4) The central bank is responsible in law to the sovereign government, which is its only client government and which is both client and owner. (The Fed makes the cut because of Presidential appointment and Congressional oversight of Fed governors).

It is only under this conditions that a central bank can control interest rates and can use inflation to control its debt, debt to control inflation and the central bank has a powerful source of leverage in its control of the interest on government debt. Further it is only under these conditions that a sovereign cannot default through lack of funds.

Under this definition, no Euro country is a sovereign borrower, not even France and Germany. It should have been obvious to European governments that all Euro area countries were opening themselves the possibility of a hard default through lack of funds in a way that wasn't true previously from the moment the Euro started to circulate.

rsj: You missed the point of my story response about California and Florida. Rather than continue with that story, let me tackle your second response as that might get to the bottom of the matter faster:

I feel like we've skipped a few steps here. We started with a very strong claim: a currency union must have internal transfer payments in order to be stable. I argued that claim was surprising because transfer payments do not change output, under the monetary policy regime of the EU. This must be so, because all fluctuations in output are linked to fluctuations in the inflation-rate which is the goal variable of the ECB.

Now you seem to be concerned about who is consuming output, I fail to see an efficiency connection between who does the consumption and how much is made. The same output is made in both cases. So whether one distribution of consumption is better than the other is a moral question.

So... consider, if there were no union and no transfer of consumption, your complain would remain. So no, it isn't that fiscal transfers are required for a currency union to be stable; it is instead that you think fiscal transfers are required in themselves.

No doubt, you're thinking now: but if it weren't for the currency union, there wouldn't be unemployment in that region over there. My concern with that claim is that if there is no excess demand for money, there is link between the common monetary policy and unemployment. So let's assume that since the CB is going the best it can, any increase the provision of hot money will induce inflation. So no more hot money is provisioned.

So, how can there be an excess demand for money in one country and not in the other? It seems to me that there is a contradiction. The fundamental characteristic of an excess demand for money is an inability to sell *anything*, but if when the CB creates more hot money and there is induced inflation then it must be the case that sellers cannot be found at the lower price.

There is plenty going wrong in Greece (and Spain) I just don't agree you can claim those things are due there being a common currency per-se. Greece is particularly bad off because there is an expectation that obligations will soon become denominated in drachmas. Debtors want to settle in drachmas and there are no drachmas, so they aren't settling, but this isn't a problem that there is a currency union. It is a problem that one debtor (the Greek government) is perceived as having the right and the motivation to declare that all debts in that country are going to be paid in drachmas instead of euros.

I have a real problem with the claim that the instability here is arising from the lack of transfers to greece. The instability is arising because there isn't a strong commitment to back the fiat currency by the force of law within Greece.

There is a missing feature of the Euro system; it is a believe that par will be maintained. Though clearly this is an accident as commentators are want to remind us that the Euro treaties contain no exit clauses--and of course they don't. The implicit creation of an exit clause, by claiming that a grexit is anything other than banditry is precisely the issue which is crippling those countries now.

(There is also some evidence that HICP which the ECB is using as its inflation measure is unstable and wrong but that's another layer of the problem).

A currency union must have fiscal transfers or substantial regional mobility of goods, labour and capital in order to avoid regional unemployment, which can threaten the unity of political federations.

I think this is a strong claim:I argued that claim was surprising because transfer payments do not change output, under the monetary policy regime of the EU. This must be so, because all fluctuations in output are linked to fluctuations in the inflation-rate which is the goal variable of the ECB.

It suggests

1) That output is independent of price volatility. Imagine an extreme scenario in which the nation is divided into two regions. Region 1 experiences a 20% increases in prices, and region 2 experiences a 20% decrease. The sum of inflation is zero. But the sum of total inflation volatility is not zero. Even according to standard sticky price models in which price stickiness is the only non-utopian force allowed by the modeller, still the aggregate output of the unified region will be less than what it would have been if both regions had stable prices. The region with 20% inflation does not produce enough "extra" output to make up for the output lost by the region with 20% deflation. But a central bank is forced between pushing the output loss onto region 1 or onto region 2, because it must choose which nominal rate to set -- the appropriate rate for region 1 or that for region 2.

2) That monetary policy can adjust agg demand without transfers. If you truly believe that, then you must believe that if the U.S. eliminated unemployment insurance, deposit insurance, as well as food stamps, that our output would be the same in this recession than if we had not eliminated them. I can understand why some models might point to this outcome, but it is just a shortcoming of th e model. In our world, income insurance programs are critical to maintaining output, which is why we do not rely on the central bank alone to manage aggregate demand, but also have automatic stabilizers.

Now, given 1) and 2) for our mythical region. if the economy is overheating in one region, causing inflationary pressures, then a transfer program to the depressed region is what funds the automatic stabilizers that reduces the decline of output in the second region while also reducing the inflationary pressures of the first region. This is something that the central bank cannot address because it must pick one interest rate for all regions.

Studying OCAs, I never managed to convince myself that cities belonged in the same currency area as the countryside. While the two traded extensively, there are so many asymmetric shocks that they just don't seem well suited to share a currency. I eventually convinced myself that currency unions mostly reflect political or other realities rather than Mundell's theory of OCAs.

So I think David sums up the discussion in one sentence; fiscal transfers aren't there for a fundamental economic purpose, but for a political one. They (may) make continued membership in a currency union politically sustainable even in the face of adverse and asymmetric shocks. In a frictionless world, those shocks just move activity (production, consumption, factors) from the less- to the more-favoured region. That's "South" to "North" these days in Europe or "East" to "West" in Canada (yes, I'm including NL as part of that "West".) In a world like that, fiscal transfers don't do much.

But when prices are sticky, resources don't move much because they don't get the right price signals. And if some factors are more fixed than others, the more fixed factor takes the brunt of the adjustment. If the fixed factors vote, they will rationally seek ways to alter that outcome. Common reactions can include devaluations and/or the imposition of capital controls (to try to keep other factors from moving.)

David writes: "A currency union must have fiscal transfers or substantial regional mobility of goods, labour and capital in order to avoid regional unemployment, which can threaten the unity of political federations."

I agree with this statement, but I find it extremely broad so as to be meaningless. How can one have a common CB without then linking the capital markets of the regions?

I'm not sure that qualifies as a currency union though if you cannot take the currency past the border and cannot tried. I also agree that such an economy would suffer unmanaged boom/bust cycles due to AD shocks if there was no monetary policy (e.g., it was a pegged regime or the supply of currency was fixed in advance).

Another way of viewing the value of an automatic fiscal transfer mechanism is to see it as a form of insurance against the worst asymmetries when the monetary authority makes "mistakes."

Prior to the crisis nominal GDP was growing more or less at a constant 4.3% annual rate in the eurozone. The economy may have been running a little hot on the periphery and a little cold in the core, but in aggregate things were pretty good with inflation close to the implicit target and the estimated output gaps by nation, whether positive or negative, of inconsequential magnitude. Now however, nominal GDP is some 12% below trend and the only nation that anyone can reasonably argue is performing alright is Germany. Consequently all of the economic performance variance is on the downside. Ireland for example is still some 20% below peak real GDP after four years.

Were nominal GDP brought back to trend by the ECB I suspect the old "not too hot, not too cold" situation would be restored. But given that the mistake has been made, the costs for the inhabitants of the GIIPS and BELLs are proving to be enourmous, and the situation is proving to be economically and politically destabilizing for the eurozone as a whole.

I agree with this statement, but I find it extremely broad so as to be meaningless. How can one have a common CB without then linking the capital markets of the regions?

I'm not sure that qualifies as a currency union though if you cannot take the currency past the border and cannot tried. I

I think the capital markets are unified, which is the problem. Anyone can own a share of BMW, regardless of where they are located. You can move currency and stock certificates with effectively zero friction from one nation to another.

But real capital, in this case the physical plants, the Bavarian industrial tradition, generations of skilled machinists, designers, relationships between engineering colleges and apprenticeship programs -- that is not something that instantly moves from one place to another when a stock certificate is sold.

You have firms rooted in geographies whose shares are traded on the unified equities markets, and who must sell bonds into a unified financial market, with a common risk free reference point, irrespective of local savings demands. I don't think the heterogeneities are properly accounted for.

Nick, I think that introducing diferent demand policy because of the ECB's incapability to manage internal demands optimaly, there iis a reason to say that two country with permanent diferencial in productivity must nave its own Central Bank? See

I wonder if the Balassa-Samuelson effect is relevant to this discussion. My understanding is that the productivity/real exchange rate relatioinship stems from the Balassa-Samuelson effect which explains the "fact that countries with higher per capita real incomes have a higher real exchange rate. " The sequence is growth in producvitity in tradable sector -> rise in tradable sector wage -> rise in wage in non-tradable sector -> increase in relative prices of non-tradable -> increase in real exchange rate. I am not sure how "permament" productivity differences come into play and perhas that is the central question being asked.

I believe Prof. Choudri and others at Carleton have been looking at this subject e.g. PRODUCTIVITY, THE TERMS OF TRADE, AND THE REAL EXCHANGE RATE:
BALASSA-SAMUELSON HYPOTHESIS REVISITED with this conclusion: This result provides a potential explanation of the mixed empirical results that have been obtained on the relationship between productivity and the real exchange rate.

I think your confusion is based on the fact that you ignore two important facts. One is that if two countries have a productivity differential, all other things equal, it's not that the exchange rate will settle at a *level* different from one, but rather will change at a *rate* different from zero. This is something you cannot of course do in a currency union. The other thing (probably more important in practice) is monetary policy, such as the inflation target and (base) interest rate. When countries have different productivity, they can stabilize their exchange rate by having different monetary policies, for instance by setting different interest rates. This is also not available in a currency unit, where monetary policy is set by a single central bank (ECB). Note that this is precisely what caused the large current account imbalances from the core to the periphery in Europe that were the real cause of today's crisis (according to the economists that did not get it miserably wrong.) (Large) fiscal transfers can correct for those lacks of monetary differentials and exchange rate change differentials in the presence of productivity differentials. And the US states are a clear case study showing this.

Christiaan: "I think your confusion is based on the fact that you ignore two important facts. One is that if two countries have a productivity differential, all other things equal, it's not that the [real NR] exchange rate will settle at a *level* different from one, but rather will change at a *rate* different from zero."

I edited your quote to add the word "real", and adding that one word makes all the difference. First, while the *level* of the productivity differential *may* affect the *level* of the real exchange rate (a la Balassa-Samuelson, for example), I don't see why it should affect the rate of change of the real exchange rate. But even if it does affect the rate of change of the real exchange rate, a small difference in inflation rates across the two countries could create that changing real exchange rate, just as easily as a slowly changing nominal exchange rate.

The problem with fixed nominal exchange rates is when the real exchange rate has to change *quickly* from one level to another, or change direction *quickly* from increasing to decreasing. Because price and wage levels, and inflation rates, cannot change quickly.

Of course, the whole question of this post is really about the long-run neutrality (and super-neutrality) of money, just under another guise. Just as the long run level of the money supply doesn't matter for real variables, nor does the long run level of the nominal exchange rate. It's the same thing. And if we are talking about *permanent* productivity differentials we are talking long run. But I carefully avoided the words "neutrality of money" because I knew if I said them it would bring all sorts of people and arguments out of the woodwork.

Noquis: I read your post, and I disagree. Why should permanent productivity differentials cause a balance of payments deficit/surplus (why should the poor country always borrow from the rich?) and even if it does, why should flexible exchange rates help solve that?

But if you read BSEconomist's and Simon van Norden's comments above, you will see that they do in fact sketch out an explanation for why this might be so. Basically, differences in initial capital/labour ratios cause productivity differentials and also cause balance of payments deficits. And BP deficits have a tendency to do a "sudden stop". And flexible exchange rates can handle the shock of that sudden stop better than fixed.

Theirs is a good and logical argument. I'm not 100% convinced, but it's not implausible. But if their argument is correct, it means that only *some* sorts of permanent productivity differentials (those caused by different capital/labour ratios) preclude an OCA. Plus, what they are really saying is that two countries that have different natural rates of interest *for whatever reason* do not belong in an OCA. Their argument has nothing to do with productivity *per se*.

I'll mention again the notion that permanent productivity differentials favour different regional policy preferences, which then generate the asymmetric response to general recession. Then one can invoke the standard OCA insight. No need to invoke exotic theories of capital crises.

Mundell recognized the tradeoff, not me. But all macroeconomic goals are political ones, ultimately, are they not?

I do wonder whether the element of labour mobility is less about resolving labour market disjunction and more about the propensity of each region toward nationalist separatism. Strong federal governments provide a safety valve, really, a la Rodrik's trilemma - when jobs seem to flee across the border, one either champions stronger local policy or global regulation.

@Jon

As Lord points out, Germany will bail out German banks but not Greek banks. So there's the imperfect capital market, since now capital is no longer treated identically.

In my opinion, the BSE/SvN argument, for why countries with permanent productivity differentials do not belong in the same OCA, is a good argument, and is the best I've seen. Now I'm going to get really picky, and dump on that argument.

1. The association between permanent productivity differentials and balance of payments deficits is weak, both empirically and theoretically. Differences in marginal returns to capital due to different capital/labour ratios are only one possible cause of permanent productivity differentials. And this is only one possible reason for running a current account deficit. It would be much better to say that countries which have differences between national savings and investment for whatever reason, so that one wants to borrow from the other, should not belong in the same OCA.

2. The theory of "sudden stops", and their impact on the equilibrium real exchange rate, is only sketched. It *may* be that sudden stops do not always require the real exchange rate to depreciate quickly. It *may* be that sudden stops are only associated with certain types of balance of payments deficits, and that balance of payments deficits associated with permanent productivity differentials do not (for some reason) cause sudden stops.

Hmmmmm. Why can't there be a "sudden stop" *inside* a country, where the lenders all suddenly stop lending to the borrowers? Is a "sudden stop" just the cross-country equivalent to a "Minsky moment"? Is there something that monetary and/or fiscal authorities can do if a sudden stop happens inside one country that they can't do if it happens between two countries with a common currency? Is this really just another way of saying that countries with a common currency have problems in creating a LOLR for national banks and governments?

Kathleen: Certainly the mechanism I talked about, with factors moving across regions, is part of standard Balassa-Sameulson modeling (which I had drummed into me as a young lad by one of Robert Mundell's best students.)

"I think your confusion is based on the fact that you ignore two important facts. One is that if two countries have a productivity differential, all other things equal, it's not that the exchange rate will settle at a *level* different from one, but rather will change at a *rate* different from zero. This is something you cannot of course do in a currency union."

I do not understand these "facts." I would have expected a relationship between productivity differentials and the level of the exchange rate, or between a productivity *growth* differential and the *change* in the exchange rate.

I also think that real exchange rates move in a currency union. But why believe me when you can check for yourself? (1) download the CPI (all items) for your favourite Canadian cities. (2) Calculate their ratios. Those are indices of real exchange rates between those cities. ;-)

"Are there even any general theories relating financial crisis to OCA?"

Yes. No. It depends [I'm channelling my inner Nick this morning.]
I don't think there's a general theory on the break-up of currency unions just because they are usually broken up for political reasons (states disintegrate -- think of the collapse of the Ottoman empire or the USSR.)
On the other hand, there's a vast literature on the collapse of fixed exchange rate regimes (PK was perhaps *the* seminal modern contributor and I think it was mentioned by the Nobel Prize committee.) And the literature on the collapse of the gold standard is big enough that it could physically crush us all!

It would be much better to say that countries which have differences between national savings and investment for whatever reason, so that one wants to borrow from the other, should not belong in the same OCA.

This is true of many regions in unified nation-states with one currency, however. Structural industrial change and demographic shift happen all the time, with ensuing investment and disinvestment. One only has a problem when bets go wrong, politicians start arguing over who gets to realize the loss, and suddenly ancient nation boundaries become relevant as possible fracture points.

Maybe instead of an optimal currency area, we should call it an optimal banking insurance area.

2) I was trying to be positive, not normative. I tried to stop short of saying that they don't belong in the same OCA. Instead, I suggested that it might make voters in one region quite upset. The frictionless long-run solution suggests that we maximize efficiency by transferring resources to the more productive region. Fiscal transfers help prevent that....and suddenly we're talking about Harper's EI reform.

Nick: "It would be much better to say that countries which have differences between national savings and investment for whatever reason, so that one wants to borrow from the other, should not belong in the same OCA."

Now you're making me think!

Okay, so here's my model;
- Cities are filled with young folk who work.
- The countryside is filled with old, retired folk.
- Folks are net debtors when young and net creditors when retired.
- No productivity growth or shocks.

We'll obviously want the countryside to run a trade deficit with the city (financed by all the interest payments they get on the capital account.)

Well, I don't know really. Now I see te BS argument in Kathleen's post a necesary condition to my argument. I'm truly confuse, because the (growing) diferencial between Spain and Germany is so evident, that I cannot see how they don't play a role in this story

Sorry, me another time.
Perhaps it is necessary to introduce a higher saving rate in te more productive country. Al diferencial in productivity plus a diffrencial savings rate. All other things equal. I tihink that Saving tate diferencial is not sufficient condition.

Perhaps Johnson and Krugman make the assumption (which turned out to be true) that lenders would fail to factor the increased country risk (increased, because borrowers would not have the exchange rate instrument for dealing with shocks) and instead look only at lower exchange rate risk. This error led to excessive lending and permitted borrowing countries' wage and price structures to get out of line with those of their currency union partners. With borrowers' real exchange rates out of line and no way to adjust nominal exchange rates, lenders were in a bind. Likewise perhaps they assume that ECB woud fail to raise average Eurozone inflation to levels that would permit borrowers' wage and price levels to slowly come back into line without big reductions in nominal wages and prices.

There were certainly suddenly stops in the US predating the Fed, and I would be surprised if there wasn't in the 30s though I haven't looked at the pattern of bank failures then. Even a LOLR doesn't assure they will act as one. Regional tensions, cross of gold speeches, quite a familiar scene, even to how much respect a "foreign" bank was due.

For one of the preeminent market monetarist blogs in the econoblogosphere, why is there no mention of nominal GDP growth in this entire thread?

Productivity growth rate differentials matter because they can translate into nominal GDP growth rate differentials via Balassa-Samuelson and elastic aggregate demand curves. This then creates the pressures on exchange rates that gets translated into internal devaluation. As Scott often reminds us, "You decide whether a currency is under or overvalued by looking at whether aggregate demand is at an appropriate level." And what measures aggregate demand? Nominal GDP. Note that this nominal GDP differential persists no matter what the central bank does. Because all the European states are bound by the same currency, there's no way to effect a monetary contraction in some regions while expanding in others. Monetary policy can raise mean growth, but cannot selective expand and contract individual countries.

By refocusing on nominal GDP, a lot of the questions Nick and others are asking become much clearer. A permanent differential in productivity growth matters because it implies a permanent differential in NGDP growth, which causes pressures for an exchange rate to change. But because the euro pegs the exchange rates all together, the pressure manifests itself as internal devaluation, which carries very severe negative consequences on count of sticky wages/prices and safe asset shortages. A permanent differential in productivity levels doesn’t matter as much because if productivity growth rates are the same, there is no differential in nominal GDP.

Fiscal transfers work because they affect regional NGDP growth. Fiscal transfers are a crude way of "taking" aggregate demand in one region and putting it in another. But when one country has permanently higher real growth and nominal GDP growth, that country will be permanently paying transfers to the others. This is the political problem to which Krugman and Johnosn refer. These permanent NGDP differentials necessitate a one-sided transfer union, which we do not have. As a result, we see the painful process of internal devaluation in periphery countries.

A narrative in terms of nominal GDP also subsumes discussions about unit labor costs. By the New Keynesian business cycle model, lower nominal GDP growth rates arise because of higher real wages or labor costs. So the lower nominal GDP growth in the periphery raises the real wage, rendering the periphery uncompetitive. This is then a more concrete reason why internal devaluation is the only option in a world without transfers or national currencies. Unit labor (and capital) costs need to adjust.

Suppose you agree that NGDPLPT is the best policy. (Not everyone does, and I wanted this post to be a more general discussion about productivity and OCAs). You want to NGDP growth rate to be constant. But does it really matter a lot what the precise number for that constant growth rate is (as long as it's not far too low or far too high)?

If two roughly equal-sized countries shared a common currency, and one had 2% productivity growth, and the other had 1% productivity growth, and both had the same 2% population growth, then if the central bank were targeting 5% NGDP growth, one country would have 4% NGDP growth and the other would have 6% NGDP growth. (Roughly). No big deal?

@Mark
I apologize for my oversight. I actually read your comment before writing my post, and I guess I should have been a bit more precise. My point was not that nominal GDP hadn't been mentioned, but rather why hadn't differentials in nominal GDP growth hadn't been zeroed in on as a possible cause for currency imbalances. Your post seemed to be more of a general comment on the collapse in average nominal GDP, whereas what was intriguing me was why the variance in nominal GDP hadn't been identified as a possible explanatory factor for why the Euro can't stay together. Thanks for reading, and I appreciate the support!

@Nick
My point is really not about the efficacy of NGDPLT. My argument was that even in an ideal world of NGDPLT at a certain k percent (agreed that the percent is not that important), differentials in nominal GDP growth are still problematic. I like to think about this from a steady state situation, and then add a few shocks.

So we start with two equal sized economies, A and B, both with real growth of about 2% and inflation at 3%. They are governed by a central bank that controls the total money supply of the currency union. A positive shock to real growth rates kicks A up to 5% real growth and 2% inflation, while B stays put. The central bank, observing the increase in NGDP, contracts the money supply such that A is at 4.5% real growth, 1.5% inflation, while B falls down to 1.5% real growth and 2.5% inflation. B has now fallen into a recession, with all of the attendendant transition problems. Note that this shock doesn't even have to be in different directions for different countries. Once a positive productivity shock hits one country, immediately we start having problems in differentials.

You assume that the economies start out from different real growth rates, so the differential in nominal GDP growth shouldn't matter as much. But as soon as there's a shock somewhere, the above steady state analysis still applies.

One possible adjustment mechanism is if B returns to its natural rate of 2% faster than A gets back to 5%. This way, the central bank tightens as B gets closer and closer to a higher nominal GDP growth rate, which lowers A back down closer to B. However, this is very unlikely as the higher productivity countries are usually the ones with more flexible labor markets that would permit the faster adjustment. If shocks were symmetric, there would also be less of a problem. But it also seems unlikely that Greece would get as many positive productivity shocks in its service industries as Germany would with its high end manufacturing.

In a sense, a lot of the problem arises from adjusting to the productivity differential and then adjusting to the different nominal growth rate. But in a world of highly leveraged banks and sovereigns with large debt burdens, these nominal readjustments can have highly non-linear effects. This is a large reason why a robust system of transfers is important, as they can readjust as soon as the productivity shocks hit and then raise expectations of future nominal growth in the lower productivity areas. As we can see from Europe, large mosaics of heterogeneous economies bound by one currency are highly fragile, and transfers go a long way torwards protecting against those fragilities.

If exchange rates float, a country's consumption will eventually always be brought in line with its production.

If the exchange rate is fixed, or abolished, one country's consumption can rise while another one falls. Greeks buy more stuff than they make. They buy it from Germans, who sell them stuff. They use the money to buy Greek debt. The private sector no longer does this, so Germany et al now lend public money through various bailout schemes. They'll have keep doing this as long as the production/consumption gap persists. The 'crisis' is the simple fact that this is necessary.

The EU has been trying to get Greeks to consume less, by cutting government spending, laying off workers etc. However, this also makes them *produce* less, since a laid-off worker is not productive (strange how that sounds).

The Germans have some vague ideas to raise production, which they call "structural reforms", but frankly I doubt any of these will work in the short term.

Krugman et al are saying that, as long as it stays in the eurozone, Greece must be provided with the extra cash to consume more than it produces, and it makes more sense to give it rather than lend it, as it's spent on German goods anyway.

In Canada, Northern Ontario produces less than Southern Ontario, because of long-term structural and geographical factors. The Ontario government does not lecture the region about "structural reforms". It provides the north with extra cash, in the form of public services, which are mostly handed out per head of population, not per unit of per capita income. We don't often hear southerners complain about lazy northerners; they're our people and we provide them the schools, hospitals, etc. they need. Germans, however, don't think of Greeks as their countrymen. Hence largely mythical stories about Greeks retiring at 50 that dominate German tabloids.

If Germans aren't willing to do fiscal transfers, they should let Greece exit the euro. Then Greek consumption will fall to match production, as the drachma price of everything will rise sharply. There is no easy way to do this.

It is both a strange and a funny feeling when I see you all talking about “productivity differentials”.

I had yesterday promised a “Ordnungspolitik view” and “determinant” already knew that it is wrong, before I spent a single word on it : - ).

Then I thought I first try to describe a little bit the reality outside, and then come back to what different models of the world (Krugman, Ordnungspolitik) have to say about it.
Then I realized that maybe your “reality” is actually different from mine, with respect to what we talk about here.
And then I was coming back to the fundamentals of the western productivity revolution.

First, if somebody is able to produce 2 bushels of wheat instead of 1, with the same input and some “new technology” (like slaves, cough, in the Roman case), then his productivity goes UP, but for the normal farmer next door, he gets his “PRODUCTIVITY DOWN”, because of the price drop due to the competition. Productivity is measured in DOLLAR / hour, and not bushels or gallons (of beer : -) per hour.

This is the very basis of all western progress, produce something cheaper than before, and that means that the traditional is LOOSING, to the benefit of the customer.
That way we shrank our agricultural workforce from 80 % to 1% in the last 200 years (2% relative per year, this number is actually very typical for “productivity change per input”), outputting of textiles and related, textiles during the 60ties, coal in the 80ties, porcellaine in the 80ties, a lot of manufacturing in the 90ties.
During this process, both employers and employees always have the choice to accept shrinking wages (or nominally stagnant, with 2´% inflation), shrinking (zero) profit margin. Or to call it quits, when some significantly better alternatives arises. Nothing new under the sun.

In areas, (and those are only loosely correlated to currency / state boundaries !!) via the so called Ballasa- Samuelson effect wages rise (typical correlation around 0.5), somebody earning 100k is more willing to pay 20 for a haircut, than somebody earning 20k. That can lead to the “dutch disease” making other industries uncompetitive, because of wages too high.

And I think the “greek disease” is, that the state and state / union controlled companies have a way too large share, and with endless EU subsidizes, debt financed just destroyed, not only hampered their private sector, resulting in the dismal export fraction. Paying fantasy wages.

Now, finally coming to the more detailed present day reality (in my place) and the overarching Ordnungspolitik.

Reality:
In Germany we have 489 “tariff contracts”, regulating wages and conditions across 16 “Länder” and about 14 business sectors (metal, chemistry, construction, baking, public service, you get the idea)
Entry level wages in the baking industry can vary between 8.05 (NRW) and 11.92 (BY), that means 48% difference.
In the metal industry, (ERA EG5, other levels look very similar, I was not “data mining”) base wages can vary from 2835 per month in Osnabrück / Emsland to 2167 (NRW) (31% difference in adjacent highly populated regions !!)
In Dresden the wage level in semiconductors did vary by 20 % between 2 factories just 1 mile apart.

In good years people get a 10 – 20 % profit sharing, in bad years none. In very bad years (2009) wages are cut 10 % (Kurzarbeit)
When I buy the exact same kind of canned tomato from the same grocery chain (LIDL)in Dresden the price is cheaper by 30 % compared to north Italy (and that is typical, and not just for tomato, although the tomato are surely not from Germany, canning can be done everywhere, and transport costs are negligible (maybe 2%).

Bottomline, in reality:
There is no “law of one price”,
no “law of one wage”, they vary from local region to adjacent, within 1 mile, from year to year, from business sector to business sector, with age and experience.
Industries, which are dying, first reduce wages, then the most unprofitable companies die, one after the other, until usually only some token remains, which can sell at fantasy prices to a few aficionados. That is the way of life, and the very core of the western productivity revolution.

In all this, there is NO need nor use for the interference of the Government, the Central bank, all kind of Europe agencies, or the usual do-gooders and busy bodies at IMF, worldbank, BIS, OECD.

Greece has got humongous subsidies over the last 30 years (20 Marshall plans) , and is the poster boy that this primarily provides a massive moral hazard to develop a deeply parasitic mindset, this sense of entitlement to permanently feed on other people.

In (my) reality all this silly (Paul Krugman and acolytes) hyper simplified theories have no relevance. Borders, currencies, OCA do not appear (significantly). People make all the time their own choices, which very often include a lot more than just a wage (level). There is neither need nor room for reality distorting transfers. Prices and wages, and their differences direct people to more profitable / amicable alternatives. Period.

Funny stuff like NGDP ? Why on earth should real GDP grow just to a simple exponential fit curve? What use has some artificial number like NGDP?

Real economicy is an eternal up and down. For Germany, when the Chinese decide, they don’t need as much shiny german production machines or BMW, first we reduce overtime, no bonus this year, use up Arbeitszeitkonten, do not increase wages, do not hire new workers, do Kurzarbeit (including training workers on new stuff), layoff temp workers, find new business fields, lay off “Stammarbeiter” , close a whole factory, …..
We have been through this in varying degrees, several times. That is live !

"Krugman has also made important contributions to the analysis of international monetary
economics. A framework of analysis that set a new standard in the study of currency crises
was proposed in Krugman (1979b). Here, he assumed that a government is trying to maintain 18
a fixed exchange rate despite some fundamental imbalance (for instance, the country has a
higher long-run inflation rate as compared to the rest of the world) that makes such a peg
impossible to maintain in the long run. By buying and selling currency in large amounts, the
government can maintain the fixed exchange rate in the short run. Krugman analyzed how
the expected future depletion of the government’s currency reserve would be taken into
account by rational investors, so as to ignite a speculative, early attack on the country’s
currency. Krugman’s simple model captured the essential mechanism of currency crises in a
way that has inspired considerable later research."

You can find the original at http://www.nobelprize.org/nobel_prizes/economics/laureates/2008/advanced-economicsciences2008.pdf

I expect there were those against the euro and if they had prevailed they would probably be better off now, but having it, must face the problems it created. The question is not how much aid will be given to the periphery, but how much private creditors will be bailed out by their governments, both of which are in the core. If creditor bailouts are not desired, it is really necessary to prevent them from getting into trouble in the first place. The only other possibility is to let the first creditors fail and bailout the the second, otherwise the economy implodes with debt, deflation, and default.

If California, Massachusetts, and New York have permanent productivity advantages over Mississippi and Alabama, why does our currency area work better than the Eurozone? Because of fiscal transfers and actual (as opposed to nominal) labor mobility.

For most of the history of the euro, interest rates for the debtor countries were 4% below the Taylor rule. People borrowed a lot of this free money and given the limits to productive investment, a lot of it went into asset inflation. The countries assumed a great deal of debt (counting individual, corporate and national together).

Worse, European banking rules allowed the banks to treat all sovereign debt as riskless. Since the returns were somewhat better for the debtor countries, banks bought lots of their debt, which caused the rates to converge, so government borrowing was very cheap.

Large quantities of debt make a country vulnerable to speculation against its bonds, and 2007-2008 made investors very skittish. The problems in Greece supplied a shock, and the long default drama gave the contagion time to spread. The ECB did little to stop this, and here we are.

It really isn't about productivity. Only Portugal is suffering from low productivity, and I see no reason that would have been a problem with suitable monetary policy. The ECB, however, was setting rates according to the needs of Germany, which was in recession after the dotcom crash.

Greece's problems involve social and political issues, rather than productivity. The productivity that is needed is in tax collection and government administration, For instance the lack of reliable correct public records of land title is a drag on investment.

Italy has had problems for years, but they were under control (by Italian standards) and finances looked relatively good until their debt came under attack.

In all cases the weakness of the banks has worsened the problem, and this weakness isn't confined to the debtor countries. It's not clear where the enormous sums needed to recapitalize the banks are going to come from, and the sovereigns and their banks are joined at the hip (Spain, Ireland, Belgium...).

So the real issue isn't productivity. It's bad monetary policy and worse bank regulation. Recapitalization will take trillions of euros, and the ECB balance sheet is enormous and packed with questionable assets.

I think their argument is less to do with permanent productivity differences, and more to do with permanent societal/cultural/language/population differences that make them more prone to asymmetric economic shocks.

And it's more than that. Even regions that are relatively similar will have asymmetric shocks from time to time and would need proper transfers in a shared currency union. Look at Florida and its housing bubble, for example.

Demand collapse? Well, there was this avionics manufacturer in my home town I worked for in the summer of 2004. I wanted to go back there. (leaving aside their weirdness in 2005). I checked their website. It was stale, all the jobs were from 2010 and closed in 2010. Little unprofessional, that. Then I checked the local newspaper website. Their main US customer had disappeared in the Crash of 2008, then the firm laid of 1/3 of its 200 person staff and still hasn't recovered. That explains the stale website.

Further to the demand collapse idea, I attended an interview in 2008 a three hour drive from my home. The interview ended with "We like you, we'd like to hire you, but our customers don't have any bank credit anymore (customers overseas) and have cancelled their orders. We can't hire you." They gave me gas money as a gesture of apology.

The Great Recession was transmitted to Canada through the Export deterioration. It surely exists. That's why I agree with everything Paul Krugman says. He accurately described the reality I have observed.

Nick and Stephen's views (sorry Stephen, but I honestly disagree with your conclusions) do not reflect the reality I have observed. This is why I'm the resident Lefty.

Simon
Your Krugman 1979b Paper:
Short form:
It is the classical Krugman 4 step process:
a) Stating the obvious
b) Making many (mostly hilarious or at least questionable) assumptions
c) Derive some “result” from the assumptions equations
d) Never ever compare to any reality and make sure that the “result” is not testable / falsifiable by real world testing

Works like a charm, so many people fall for this anti-science approach.

Long form:
a) It is first stating the obvious.
If your exchange rate is mismatched and you therefore run a current account deficit, (the opposite case is called bad mercantilism, and is buuh, bääh) and when your accessible foreign reserves are used up, you can’t pay anymore for imports. Bang.
That’s why you have flexible exchange rates since the end of Bretton Woods, because certain countries (erm, like the US) were not able or willing to keep their inflation under control.
That is why some folks like TE “The economist” follow those numbers since many, many years:
http://www.economist.com/markets-data
and therein http://www.economist.com/node/21557357
This was certainly not new at this time.
When this game is drawing to an end, it obviously invites speculators to sell overvalued currency, to make a profit, and to profit faster, the faster the game comes to an end.
Wow, who would have thought that.

b) Strange assumptions, drawn from thin air
Then Krugman makes a couple of completely false assumptions:
Zero nominal interest
Total real wealth just consists of domestic and foreign money (typically this is first real estate, second stock, third long term financial invest, and only fourth cash (equivalent)
“Under a flexible rate regime, since neither the govemment nor foreigners will trade domestic money for foreign, there is no way for domestic residents to alter the composition of their aggregate portfolio” Harumph ? The volume of international foreign exchange dwarfs everything else!
“A convenient, if somewhat artificial, assumption is that the govemment adjusts its expenditure so as to keep the deficit a constant fraction of the money supply “ The problem is, that they don’t control their expenditures until brutally forced by the markets.
And so it goes on and on …..
Any evidence ever to the inputs? Of course not, a Krugman doenst need reality.

c) plays with some equations
more strange assumptions: “private savings is in tum a function of private wealth, with dS/dW= - C2 < 0”

well , Simon, what would you see as a “result” of the equations gymnastic ?

d) does Krugman every compare to real world data ?
do you know anybody who ever tried to make this paper comparable to any kind of real world data ?

@ all professors here at WCI
Just show me one Krugman paper, you think has any positive value, and explain in a few sentences, why you believe that

@Mayson
Mentionable transfers to Texas came only long after the civil war, establish firm federal control over the states.

Germany has always stated that if there would be effective financial central control, one could talk about many things, but not before.

Too much “labor mobility” in Europe would be actually very bad. The folks, who are moving are the highly paid, active, intelligent, taking their taxability with them and the remainder are the brooding masses. This is actually one of my long term fears. IQ differences are already now up to 10 points.

See for example Florida “the creative class”

@Peter N
We don’t believe in Taylor rules. Inflation targeting only, please, we are Germans.
“It really isn't about productivity”
Right ! it is all about lacking adaption processes in these countries.

“The ECB, however, was setting rates according to the needs of Germany, which was in recession after the dotcom crash.”
False, first the dot-com “NeuerMarkt” was end of 1999 about 5% of GDP or 1.5 % of wealth, something within the noise of yearly change, irrelevant for developments in Germany.

Second the Mandate of the ECB was for Euroland HICP, which includes of course Germany. If the ECB would cater to German interests, Rates would be at 4 -5 % by now.

Banks are always as good as the government standing ultimately behind them.
There is no reason that everybody else bailed out there own banks, but Spain gets some extra favour (barely hidden transaction)

A) Yes, it is obvious. It is the statement of the situation he seeks to analyse. Did you think someone was claiming otherwise?

B) Krugman, like many good modellers (Lucas, Sargent, Samuelson, Solow, to name a few) presents highly simplified models. These strip away much that is inessential to make a specific point. Yes, many of the assumptions are false. In fact, all economic models are false. However, some are useful.

C) You're probably the first and last person to complain that Krugman is too mathematical.

D) "Do you know anybody who ever tried to make this paper comparable to any kind of real world data ?" Yes. Perhaps if you used the internet, you could find some too.

"@ all professors here at WCI
Just show me one Krugman paper, you think has any positive value, and explain in a few sentences, why you believe that."

I think my previous quotation from the Nobel prize committee did just that. If you followed the link in my previous post, you would find more of Krugman's work that the committee cites. (Yes, the committee is made of professors.) They also explain, briefly, why it is valuable. Actually, they explain it twice; once for economists and once in non-technical language.

"The point is that his math has no value, because it builts on arbitrary and strange assumptions"

Yes. It is math. One could argue that all math builds on arbitrary and strange assumptions. When we apply mathematics to the real world, we often find that our models are simpler than the real world. I'm not sure why this upsets you so. I'm not sure why you feel this is Krugman's fault.

It's a shame that the various resources I've mentioned to you have not satisfied your thirst for knowledge.

The Robert Feenstra Eulogy.
I read this obviously with very different eyes.
This is Feenstra’s eulogy to his admired academic teacher, or in more rude words, a shameless (white) lie. Including the eternal self grandeur of pure macro economy theoreticians taking themselves way too important, especially while ignoring reality.

Just a few examples:
That economic integration with the sole neighbor USA is beneficial for Canada with a 2500 mile border and 75 % of the population living less than 100 miles away from that border, is a non-brainer. You don’t need a little abstract paper for understanding that. The question is more, why it took until 1992 to formalize this.
Many countries outside the western world, like Latin America, India, China tried to develop their own industry by systematically shutting out western imports with at least stiff tariffs.

Central Europe chose a different path by systematically integrating the markets, gaining economy of scales. Montan Union ca 1950, EFTA 1960, EEC ca 1970 (somewhat dependent on your viewpoint)
Did this hurt the smaller countries, like Dutch, Danes, Belgium? I don’t think so. I think it is common sense, that this helped a lot in countries like Ireland, Spain, Portugal, Italy to catch up.

When “Nixon went to China” in 1975 this was also the key Marker, that China realized that this technology autarchy is bitterly failed, long before any Krugman. Other countries needed a little longer for that.

GATT started in 1948, Kennedy round, Tokyo round 1973, all this without any Krugman.
And that the US just 40 years later realized, that being also formally nice to its neighbors Mexico and Canada, and to form a NAFTA 30 years after the EFTA, is then evidence for Feenstra, that this has anything to do with Krugman.
Big stretch in my view.

The same goes for the other claims. Regional concentration of economic activity around centers. Sure an interesting topic. But if you look at what Krugman did, and ask what is new, and you always end up with these “results” which are uncomparable to reality, where people 20 years later write in an NBER paper, that after mangling the data substantially, they get at least, for the first time the sign of the effect right ? What is this?

How terms of trade and exchange rates influence current account flows? An important question, with assets scattered across the world. After I figured that out, roughly for myself (http://www.slideshare.net/genauer/currencies) I realized “silly me” there have to be papers out there for that, stumbled upon Fleming Mundell, who Krugman is careful not to cite in his books, and then there should be the famous Krugman. I looked at the paper, and thought, what do I learn from that, with respect to reality. Nothing.

Maybe there is something out there, which I just overlook. But to find this, I would need somebody who actually read those papers, understood them, and can explain / defend them, talk back, react to questions, like a WCI professor, and not just like a dead bone left over from some anonymous comitee.

I spelled Muphry's Law correctly. It was 'pseudonymous' I got wrong, in a confirming instance of Muphry's Law.

To make sense of your criticism of Krugman's Nobel, it might clarify things if you told us which other recipients were undeserving in your view and/or which ones truly earned their gongs. Or you could say who should have got one and didn't.

What I was asking for, is that somebody who is qualified to talk back, shows me one Krugman paper, and tells me why that specific paper has merit.

And I would very much like to stick with that. Therefore it is with great hesitance that I say I like Modigliani, and as much as I like Hayeks "The road to serfdom", I wondered about his Nobel. But again, I dont want to discuss Nobel prices, but Krugman papers.